Chapter Six

Variable Interest
Entities, Intra-
Entity Debt,
Consolidated
Cash Flows, and
Other Issues

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
LO 1
Variable Interest Entities (VIE’s)

 Known as Special Purpose Entities (SPE)

 Established as a separate business structure
– Trust
– Joint Venture
– Partnership
– Corporation
 Frequently has neither independent management nor
employees
 Typical purposes
– help finance their operations at favorable rates
– Transfers of financial assets
– Leasing
– Hedging financial instruments
– Research and development
 Off-balance sheet financing
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 Variable Interest Entities

Characteristics of VIEs:
Most established for legitimate business purposes
Some created to avoid consolidated disclosure
Generally have assets, liabilities, and investors
with equity interests
Role of equity investors can be minor if VIE’s
activities are strictly limited
Equity investors may serve simply to allow the
VIE to function as a legal entity

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 Variable Interest Entities

Characteristics continued. . .
VIEs bear relatively low economic risk, therefore
equity investors are provided a small rate of return.
Another party (often the sponsoring firm that
benefits from the VIE’s activities) contributes
substantial resources – loans and/or guarantees – to
enable a VIE to secure financing needed to
accomplish its purpose.
The sponsoring firm may guarantee the VIE’s debt,
assuming the risk of default.

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 Variable Interest Entities

Characteristics continued. . .
Contractual arrangements limit returns to equity
holders yet participation rights provide increased
profit potential and risks to sponsor.
Risks and rewards are not distributed according
to stock ownership but by other variable interests.
Sponsor’s economic interest vary depending on
the VIE’s success – Hence the term variable
interest entity.

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 Variable Interest Entities

FASB standard FIN 46R3 requires the primary

beneficiary (regardless of their ownership) to
consolidate the VIE.
Who is the “primary beneficiary”?
The firm that has the:
• Power to direct the activities of the VIE that
significantly impact the entity’s economic
performance.
• Obligation to absorb significant losses of the
entity.
• Right to receive significant benefits of the entity.

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 Benefit of VIE’s

A business sponsors a VIE to purchase and

finance asset acquisition.
– The VIE leases the asset to the sponsor.
– VIE is often eligible for lower interest rate.

The VIE has limited assets. This “asset

isolation” and limited activity separates the
VIE’s creditor(s) from the overall risk of the
sponsor.

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Variable Interest Entity - Example

Assume Twin Peaks, a power company, seeks to

acquire an electric generating plant for $400
million to expand its market share.
It expects to sell the electricity generated by the
plant acquisition at a profit to its owners.
To take advantage of lower interest rates, Twin
Peaks creates Power Finance Co., an entity
designed solely to purchase the electric
generating plant, provide equity and debt
financing, and lease the plant to Twin Peaks.

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 Consolidation of VIE’s

Similar to other combinations, valuation of

assets, liabilities, and noncontrolling interest
should be based on Fair Value.

When a VIE’s total When a VIE’s total

business fair value is business fair value is
less than its assessed greater than its assessed
net asset value, a net asset value,
GAIN is recognized. Goodwill is reported.

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 Disclosure Requirements –
In Footnotes of ALL VIE Interests

Nature, purpose, size, & activities of the VIE

Significant judgments made Nature of restrictions on

in determining the need to assets and settlement of
consolidate a VIE or disclose liabilities, and the related
any involvement carrying value

Nature of risks, and how a VIE affects the financial position,

performance and cash flows of a Primary Beneficiary

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 VIE’s and International Standards

In May 2011, the International

Accounting Standards Board
issued IFRS 10 - Consolidated
Financial Statements and
IFRS 12 - Disclosure of
Interests in Other Entities.

The standards include a new

definition of control designed to
encompass all possible ways
(voting
power, contractual power,
decision making rights, etc.) in
which one entity can exercise
power over another.
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LO 2
Intra-Entity Debt Transactions

A company CANNOT lend money to itself.

 Intra-entity investments in debt securities and

related debt accounts must be eliminated in
consolidation despite their differing balances.
 Corresponding receivable and payable and
revenue and interest from the consolidated
financial statements must be eliminated.
 Gain/loss on effective retirement of the debt must
be recognized in the consolidated statements.

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 Intra-Entity Debt Transactions -
Example

Assume Alpha owns 80% of Omega.

On 1/1/11, Omega issued $1 million in 10-year
bonds at 9%.
Omega issued the bonds at $938,555, with
effective interest at 10%.
On 1/1/13, Alpha purchased the bonds for
$1,057,466, with effective interest at 8%.

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 Intra-Entity Debt Transactions -
Example
Book value of Omega Company’s bonds as of
December 31, 2012, the date immediately before the
day Alpha Company acquired the bonds

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 Intra-Entity Debt Transactions -
Example
Omega Company’s bonds have been effectively
retired. The difference between the $1,057,466
payment and the January 1, 2013, carrying value of
the liability must be recognized in the consolidated
statements as a gain or loss.

Because Alpha paid $110,815 in excess of the recorded

liability ($1,057,466 - $946,651), the consolidated
entity must recognize a loss of this amount. Then, the
bond is retired and no further reporting is necessary
by the business combination after January 1, 2013.

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 Intra-Entity Debt Transactions -
Example
Omega retains the $1 million debt balance within its
separate financial records and amortizes the
remaining discount each year. Annual cash interest
payments of $90,000 (9 percent) continue to be made.
At the same time, Alpha records the investment at the
historical cost of $1,057,466, an amount that also
requires periodic amortization.
Alpha receives the $90,000 interest payments made by
Omega. To organize the accountant’s approach to this
consolidation, the subsequent financial recording
made by each company is analyzed.

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 Intra-Entity Debt Transactions -
Example
Omega records only two journal entries during
2013 assuming interest is paid each December 31
to record the interest expense cash payment
and discount on bonds payable.:

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 Intra-Entity Debt Transactions -
Example
In 2013, Alpha records its investment in
Omega’s bonds and the interest income.

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 Intra-Entity Debt Transactions -
Example
Entry B
To convert information from the individual companies to
the perspective of a single economic entity, we extinguish
the debt (it is no longer owed to a third-party). Any
gains/losses are attributed to the parent, thus, there is no
effect on Noncontrolling Interest.

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 Intra-Entity Debt Transactions -
Example
Entry *B (Subsequent Years)
Adjust the BV’s of the Bonds Payable and the
Investment in Bonds to reflect amortization.
Also, the loss is now reflected in R/E, which must be
adjusted for the difference in interest amounts.

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LO 3
Subsidiary Preferred Stock

Preferred stock, usually nonvoting, possess certain

“preferences” over common shares such as
cumulative dividends, participation rights, and
sometimes limited voting rights.

Preferred shares are part of the sub’s stockholders’

equity, treated in consolidation similarly to common.

The existence of subsidiary preferred shares does not

complicate the consolidation process. The acquisition
method values all business acquisitions (whether 100
percent or less acquired) at their full fair values.

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 Subsidiary Preferred Stock -
Example -
The consolidation entry made in the year of
acquisition is shown below:

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LO 4 Consolidated Statement
of Cash Flows

Current accounting standards require that

companies include a statement of cash flows
among their consolidated financial reports.
The main purpose of the statement of cash flows
is to provide information about the entity’s cash
receipts and cash payments during a period.
The consolidated statement of cash flows is
based on the consolidated balance sheet and the
consolidated income statement.

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 Consolidated Statement
of Cash Flows

Intra-entity Transactions
Intra-entity cash flows should not be
included on the statement of cash flows.
The intra-entity cash flows are already
eliminated from the balance sheet, so
no additional effects appear on the
statement of cash flows.

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 Consolidated Statement
of Cash Flows
In the year of acquisition:
The net cash outflow to acquire the subsidiary is
reported (cash paid less subsidiary cash acquired).
Any amounts acquired are not included in the
increase or decrease of balance sheet accounts.
In all years:
Add back the noncontrolling interest’s share of the
sub’s net income.
Deduct dividends paid to the outside owners as
cash outflow.
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LO 5
Consolidated Earnings Per Share

The computation of EPS for a business

combination follows the general rules.
Consolidated net income attributable to the parent
company owners along with the number of
outstanding parent shares provides the basis for
calculating basic EPS.
Any convertibles, warrants, or options for the
parent’s stock that can possibly dilute the reported
figure must be included in diluted EPS.

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Consolidated Earnings Per Share

If potentially dilutive items exist on the

sub’s individual statements, then the
portion of the sub’s net income included
in consolidated net income may not be
appropriate for the computation of
consolidated earnings per share.

Weighted Average
Net
EPS = ÷ Common Shares
Income
Outstanding

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 Consolidated Earnings Per Share

Compute the sub’s own diluted EPS.

The earnings used in the computation
are used in the determination of
consolidated EPS.
The portion assigned to the computation
is based on the percent of the subsidiary
owned by the parent.

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LO 6
Subsidiary Stock Transactions

A parent’s ownership percentage may be

affected by a subsidiary’s transactions in
its own stock (additional issuances, or the
purchase or treasury stock).
The effects on the consolidated entity
are recorded by the parent as an
adjustment to APIC and the investment
account.
Not reported as a gain or loss of the
consolidated entity.
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 Summary

VIE’s are created to fulfill special purposes.

GAAP requires consolidation by the primary
beneficiary of the VIE.
When debt of a related party is acquired, the
debt is effectively retired.
Preferred stock of a subsidiary will often
resemble debt more than equity, and parent-
held shares will be eliminated from
consolidation as if the stock had been retired.

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